PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 311:

  Which of the following statements is true?

  I - Real Time Gross Systems (RTGS) for large value payments consume less system liquidity than Deferred Net Systems (DNS) II - The US Fedwire is an example of a Real Time Gross System III - Current disclosure requirements in relation to liquidity risk as laid down in the Basel framework require banks to disclose how liquidity stress scenarios were formulated IV - A CFP (Contingency Funding Plan) provides access to Central Bank financing

  A. I and III
  B. II and IV
  C. I, II, III and IV
  D. II
  D. II

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  Explanation

  The correct answer is choice 'd' For settlement of interbank payments, there are broadly two kinds of systems: RTGS (Real Time Gross Systems) and Deferred Net Systems (DNS). RTGS process payments in real time, settlement by settlement, and each transaction is settled by the a clearing institution (mostly the central bank) on a gross basis without regard for other settlements affecting the counterparty. DNS systems, on the other hand, allow for debiting or crediting the accounts of counterparties at periodic intervals after netting all payments paid or received since the last settlement. The exact timing of the payments does not matter so long as a bank has sufficient funding on a net basis at settlement time. Implicit in the DNS system is the extension of credit and liquidity by the central bank to the participating banks as it is possible for a bank to issue payment instructions even without having funds so long as they can arrange for such funds prior to settlement at the end of the day. In RTGS, a bank needs to have funds to make a payment at any point, and cannot make a payment against moneys expected to be received later intra-day. RTGS systems therefore need more liquidity on the part of the participants, and consume far more liquidity than DNS arrangements. Of course, the 'liquidity' of the DNS arrangement has a cost - which is that someone is taking up settlement risk, and invariably it is the central bank. If a bank under DNS fails to settle, its transactions have to be 'unwound', ie all payments made by it have to be rolled back. This can cause other banks to trip, causing further unwinding transactions. RTGS systems do not carry this risk. Therefore statement I is not correct as RTGS consume more liquidity than DNS arrangements. Statement II is correct. US Fedwire or European TARGET are RTGS while CHIPS is a DNS based payment system. Statement III is not correct. Current Basel requirements do not require any disclosure in respect of liquidity risk management. A consultative paper was issued by BIS in Dec 2009 for comments from members, but it is far from final. The BIS is still reacting to the liquidity issues that arose during the 200709 credit crisis. Statement IV is not correct as a CFP is like a disaster recovery plan for liquidity, ie it helps a bank plan for and think about what steps would be taken to deal with a liquidity disaster situation. It does not provide any access to central bank financing.

• Question 312:

  Which loss event type is the loss of personally identifiable client information classified as under the Basel II framework?

  A. Technology risk
  B. Clients, products and business practices
  C. Information security
  D. External fraud
  B. Clients, products and business practices

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  Explanation

  Choice 'b' is the correct answer. All other answers are incorrect. Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.

• Question 313:

  If the cumulative default probabilities of default for years 1 and 2 for a portfolio of credit risky assets is 5% and 15% respectively, what is the marginal probability of default in year 2 alone?

  A. 15.79%
  B. 10.53%
  C. 10.00%
  D. 11.76%
  B. 10.53%

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  Explanation

  One way to think about this question is this: we are provided with two pieces of information:

  if the portfolio is worth $100 to start with, it will be worth $95 at the end of year 1 and $85 at the end of year 2. What it is asking for is the probability of default in year 2, for the debts that have survived year 1. This probability is $10/$95 =

  10.53%. Choice 'b' is the correct answer.

  Note that marginal probabilities of default are the probabilities for default for a given period, conditional on survival till the end of the previous period. Cumulative probabilities of default are probabilities of default by a point in time, regardless of

  when the default occurs. If the marginal probabilities of default for periods 1, 2... n are p1, p2...pn, then cumulative probability of default can be calculated as Cn = 1 - (1 - p1)(1-p2)...(1-pn). For this question, we can calculate the probability of

  default for year 2 as [1 - (1 - 5%)(1 - 10.53%)] = 15%.

• Question 314:

  A bullet bond and an amortizing loan are issued at the same time with the same maturity and with the same principal. Which of these would have a greater credit exposure halfway through their life?

  A. Indeterminate with the given information
  B. They would have identical exposure half way through their lives
  C. The amortizing loan
  D. The bullet bond
  D. The bullet bond

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  Explanation

  A bullet bond is a bond that pays coupons covering interest during the life of the bond and the principal at maturity. An amortizing loan pays the interest as well as a part of the principal with every payment. Therefore, the exposure of the amortizing loan continually reduces, and approaches zero towards the end of its life. The bullet bond will always have a higher exposure at any time during its life when compared to an equivalent amortizing loan. Hence Choice 'd' is the correct answer.

• Question 315:

  Under the contingent claims approach to credit risk, risk increases when:

  I - Volatility of the firm's assets increases II - Risk free rate increases III - Maturity of the debt increases

  A. II and III
  B. I and III
  C. I, II and III
  D. I and II
  B. I and III

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  Explanation

  Under the contingent claims approach, credit risk is evaluated as the value of the put on the firm's assets with a strike price equal to the face value of the debt and maturity equal to the maturity of the obligation. The Black Scholes model can then be used to value the put, and therefore an increase in volatility and the time to expiry (ie maturity) will increase the value of the debt. An increase in the risk free rate will actually reduce the value of the put, therefore statements I and III are correct and Choice 'b' is the correct answer.

• Question 316:

  The cumulative probability of default for a security for 4 years is 11.47%. The marginal probability of default for the security for year 5 is 5% during year 5. What is the cumulative probability of default for the security for 5 years?

  A. 16.47%
  B. 5.00%
  C. 15.90%
  D. None of the above
  C. 15.90%

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  Explanation

  The cumulative probability of default for the security for the 5 years is [1 - (1 - probability of default upto year 4)*(1 - probability of default in year 5)]. An easier way to think about this is that the Probability of survival till year 5 = (Probability of survival till year 4 * Probability of survival during year 5). Using the relationship that probability of default = 1 - probability of survival, we can calculate the required probability in all cases. In this case, the cumulative probability of default for the security for 5 years = 1 - (1 - 11.47%)*(1 - 5%) = 15.8695%, therefore Choice 'c' is the correct answer.

• Question 317:

  The capital adequacy ratio applied to risk weighted assets for the calculation of capital requirements for credit risk per Basel II is:

  A. 150%
  B. 12.5%
  C. 100%
  D. 8%
  D. 8%

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  Explanation

  The capital adequacy ratio, also called the minimum capital requirement for credit risk per Basel II is 8% of risk weighted assets. The other choices are incorrect.

• Question 318:

  Which of the following statements is true in respect of different approaches to calculating VaR?

  I - Linear or parametric VaR does not take correlations into account II - For large portfolios with little or no optionality or other non-linear attributes, parametric VaR is an efficient approach to calculating VaR III - For large portfolios with complex sources of risk and embedded optionalities, the full revaluation method of calculating VaR should be preferred IV - Delta normal local revaluation based VaR is suitable for fixed income and option portfolios only

  A. I, II, III and IV
  B. I and IV
  C. II and III
  D. III only
  C. II and III

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  Explanation

  This question is different in that it uses terminology you will not find in the PRMIA handbook. Yet it is important to understand these as there may be a question based on this slightly different terminology. (It is only the terminology that is

  different, the concepts are the same.)

  If you read the PRMIA handbook, there are three methods of calculating VaR: Analytical or parametric, historical simulation and Monte Carlo simulations. There is one more way of categorizing the methods of calculating VaR, and these are

  as follows:

  1. Local valuation: This refers to analytical or parametric VaR. This relies upon a neat statistical formula to calculate VaR and assumes a normal distribution. It also relies upon a known covariance matrix between the different components of VaR. Local valuation based VaR is further subdivided into two types:

  a. Linear VaR: Linear VaR is calculated assuming the portfolio is linear, and its value changes just based upon the delta of the portfolio. In such cases, once a change (eg, in stock values) is known, that change is multiplied by the delta alone to get the VaR. Second order effects, such as gamma or convexity are ignored. b. Non-linear VaR: Non linear analytical VaR is calculated using both delta and the second derivative, ie gamma or the convexity. This is more accurate if the portfolio is non-linear. The key thing about 'local revaluation' VaR is that it does not require us to reprice or completely value all instruments in the portfolio. All we have to know is the delta (or the gamma and convexity as well) and multiply that with the number of standard deviations of change in the risk factor that we are interested in. So if we are considering a bond, we don't have to recalculate the new value of the bond as we can just use the delta. This can be a significant computational advantage for a large financial institution where there may be a large number of positions.

  2. Full revaluation: This refers to a VaR method where the asset in question is fully repriced based on the new value of the risk factor - and this includes both historical and Monte Carlo based VaR methods. Local revaluation, or analytical method based VaR is computationally easier to calculate, specially if based on just the delta-normal method (ie ignoring second order effects from convexity or gamma). But it will give incorrect results if the portfolio includes substantial nonlinearity or other complexities. The full revaluation methods will always give the correct results, but they can be computationally difficult to arrive at. Statement I is completely inaccurate - local revaluation methods do take correlations into account through the correlation or covariance matrices. Statement IV is false too - the 'delta normal' VaR refers to Var calculations based upon just the delta and do not account for the convexity or optionality. Statements II and III are correct. Therefore Choice 'c' is the correct answer.

• Question 319:

  When modeling operational risk using separate distributions for loss frequency and loss severity, which of the following is true?

  A. Loss severity and loss frequency are considered independent
  B. Loss severity and loss frequency distributions are considered as a bivariate model with positive correlation
  C. Loss severity and loss frequency are modeled using the same units of measurement
  D. Loss severity and loss frequency are modeled as conditional probabilities
  A. Loss severity and loss frequency are considered independent

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  Explanation

  When modeling operational loss frequency distribution (which, for example, may be based upon a Poisson distribution) and a loss severity distribution (for example, based upon a lognormal distribution), it is assumed that the frequency of losses and the severity of the losses are completely independent and do not impact each other. Therefore Choice 'a' is correct, and the others are not valid assumptions underlying the operational loss modeling. Once each of these distributions has been built, a random number is drawn from each to determine a loss scenario. The process is repeated many times as part of a Monte Carlo simulation to get a the loss distribution.

• Question 320:

  A financial institution is considering shedding a business unit to reduce its economic capital requirements. Which of the following is an appropriate measure of the resulting reduction in capital requirements?

  A. Incremental capital for the business unit in consideration
  B. Proportionate capital for the business unit in consideration
  C. Percentage of total gross income contributed by the business unit in question
  D. Marginal capital for the business unit in consideration
  A. Incremental capital for the business unit in consideration

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  Explanation

  Incremental capital (or incremental VaR, depending upon the context), is a measure of the change in the capital (or VaR) requirements if a certain change is made to a portfolio. It uses the 'before' and 'after' approach, ie find out what the capital requirement or VaR will be without the change, and what it will be after the change. The difference is the incremental capital or incremental VaR. It helps measure the change in risk as a result of a particular action, eg a change in a position. Marginal capital or VaR on the other hand is a method to break down the capital requirement or the VaR so that it can be assigned to individual positions within the portfolio. The total of marginal capital or marginal VaR for all the positions in a portfolio adds up to the total capital requirements or total VaR. Note that marginal VaR is also called component VaR. Therefore incremental capital is the correct answer to this question. The other choices are incorrect. In the exam, the question may be phrased differently, so try to keep in mind the different between incremental and marginal capital, which can be a bit confusing given what these terms mean in plain English.